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Wednesday, 26 June 2013

The inequality conundrum (1% and beyond)

Greg Mankiw wrote an excellent paper (forthcoming in the Journal of Economic Perspectives) that caused a lot of fuss around the blogosphere. This is hardly a surprise since the title of the paper happens to be: "Defending the One Percent". However, the paper is much less provocative than the title would imply. It is portrayed as a survey of economic ideas on progressive taxation and redistribution equiped with easy to understand examples and basic utilitarian concepts. I recommend it as an excellent argument not against redistribution (as this certainly isn't the case he's making), but as an attempt to shed more light in the controversial debate on inequality and how to approach it.

Mankiw drives a persuasive argument, similar to the one I've pointed out in a previous text, that the top 1% of income earners aren't rent-seekers or those that have inherited their wealth (an argument Stiglitz tries to deliver in his book "The Price of Inequality"; Mankiw reports his evidence as anecdotal rather than systematic). This argument is certainly true in developing countries; their rich classes are made up mostly of monopoly owners who received huge grants from the government (like Carlos Slim in Mexico for example). In the US, even though social mobility has shrugged in the past couple of decades, those on the very top are still entrepreneurs and innovators. Or in other words, people who create new value, new jobs and even give rise to completely new markets. Is there a reason to be jealous at those who gave us Google, Apple, Amazon, Facebook or Microsoft? Or Wall Mart? I understand the social ramifications of a crisis in which a lot of people have lost large amounts of their wealth (some of it is attributed, interestingly enough, to poor math skills), and all of a sudden having seen someone being significantly better off causes much more anger and discomfort. However, the innovations that have occurred since the 1970s made our lives easier (and/or cheaper), and those who made them certainly deserve to reap their rewards. And the beauty of an inclusive institutional environment is that these people could develop their ideas to the fullest and not fear their wealth being expropriated by anyone.

On the contrary, in a more extractive political environment, those who get rich do so by gaining favours from the government, or in an even worse scenario, by undergoing certain criminal activities. And sometimes both!

But this didn't happen in America.

A similar argument can be applied to those with unique skills (sports, music, acting, etc.) that the people are willing to pay to see or experience. This unique skill set extends to the banking industry as well, or any other multi-bilion dollar business. The demand, the competition and the risk are all global, and hence are the salaries. Otherwise we risk driving high-quality individuals away from the profession.

Mankiw builds upon this reasoning and explains how inequality in the US is the result of supply and demand for talented and skilled people. He calls upon the arguments of a book by Goldin and Katz (2008) "The Race Between Education and Technology":

"Goldin and Katz argue that skill biased technological change continually increases the demand for skilled labor. By itself, this force tends to increase the earnings gap between skilled and unskilled workers, thereby increasing inequality. Society can offset the effect of this demand shift by increasing the supply of skilled labor at an even faster pace, as it did in the 1950s and 1960s. In this case, the earnings gap need not rise and, indeed, can even decline, as in fact occurred. But when the pace of educational advance slows down, as it did in the 1970s, the increasing demand for skilled labor will naturally cause inequality to rise. The story of rising inequality, therefore, is not primarily about politics and rent-seeking but rather about supply and demand."

And in my own views (which I have emphasized several times on the blog; see here, here or here), these forces will continue to operate for a long time. Particularly if education continues to adapt slowly to the new pace of technological progress thus furthering the downward pressure on the labour market. If the demand for skills is higher than the supply inequality increases, more people start receiving transfer benefits, implying that less people acquire new skills, and the negative spiral continues (I touched upon this problem in a previous text). This is a crucial issue the US needs to work on and I believe this sums up the inequality debate more precisely than any other ideologically-driven argument.

I don't want to go too much into the criticism delivered by Paul Krugman or the Economist (who do raise some valid points but fail to see the big picture), nor will I attempt to dispute the income inequality data (I do accept the premise that inequality has increased, although some of this increase can be explained by other factors than the ones we usually hear) but I will point out to the issues raised by Alan Krueger, the Chairman of the President's Council of Economic Advisers a year and a half ago. He has presented the so-called "Great Gatsby curve", which measures income inequality and intergenerational mobility, where the US occupies a worrying position having experienced both high income inequality and low social mobility. This remains to be one of the biggest problems in the US. Even though entrepreneurial spirits are still highly rewarded, it is much harder for those on the lowest income levels to advance to the top decile of income distribution than it was 30 years ago. Again, this is due to a whole range of factors including a decline in the quality of education (a public policy issue) and possibly higher immigration of low-skilled individuals who have failed to assimilate due to a number of reasons (a sort of a public policy issue).

Notice, btw, the countries clustered at the bottom - those who have both low inequality (low Gini) and low intergenerational earnings elasticity (meaning higher social mobility): the Nordics. How peculiar.

In conclusion, we should acknowledge that inequality and more importantly the lack of social mobility are causing a great line of distress in America. I'm not qualified enough to answer how to fix this, since the solution lies somewhere between the interaction of education, technology, labour market inefficiencies, informal institutions and cronyism. Another important point however is not to portray profits as something inherently negative and not to try and dissolve the one thing that still makes America great - the ability to turn great ideas into great business ventures. The entrepreneurial spirit is still strong in the US, despite a great deal of (unintended) efforts to constrain it. The US should struggle to keep its innovative society, over which it has the edge against the rest of the world, and at the same time reignite their once famous system of upward social mobility. Until then, cronyism combined with an inability to adapt to the ongoing technological progress will continue to produce a bleak future for the US.